‘Only about a quarter of cash put into circulation is used to buy and sell things.’
Photograph: Murdo MacLeod for the Guardian

The chief cashier of the Bank of England says that only about a quarter of the cash they put into circulation is used to buy and sell things. The rest of it is either shipped overseas – which we will put to one side for the moment – kept outside of the banking system ie (hoarded), or used to support the shadow economy (iestashed). In other words, not in circulation at all but stuffed under mattresses.

If you look at the trend growth of that cash “in circulation” over the last few years, it has accelerated past GDP growth as well as past the amount of money being taken out of ATM machines. And we also know that the use of cash in retailing has continued to fall steadily. That means the “cash gap”, between the small amount of cash that is used to support the needs of commerce and the large amounts of cash that are used for other purposes, has been growing. The interesting question is: why?

If hoarding cash is on the up, that would suggest people have lost confidence in formal financial services

There are two pretty simple alternatives. If the amount of cash that is being hoarded has been growing, that would suggest people have lost confidence in formal financial services. Or, that they have so little knowledge of basic arithmetic that they are happy to have inflation eat away their store of value while forgoing the safety and security of bank deposits, no matter what value of the interest paid.

If, on the other hand, the amount of cash that is being stashed has been growing, the Bank of England is facilitating an increasing tax gap that the rest of us are having to pay for. In this context, cash is a mechanism for greatly reducing the cost of criminality while it remains a penalty on the poor who have to shoulder an unfair proportion of the cost of cash (they don’t get the same access to electronic payments as the rich, and have to pay to extract money from ATMs). In this case, we should expect to see a strategy to change this obviously suboptimal element of policy.

So which is it? Well, in a fascinating paper published last year by Prof Charles Goodhart (London School of Economics) and Jonathan Ashworth (UK economist at Morgan Stanley), they note that the ratio of currency to GDP in the UK has been rising, and argue that the rapid growth in the shadow economy has been a key cause. If you look at the detailed figures, you can see that there was a jump in cash held outside banks around the time of the Northern Rock affair, but as public confidence in the banks was restored fairly quickly and the impact of low-interest rates on hoarding behaviour seems pretty marginal, there must be some other explanation about why the amount of cash out there keeps rising.

Two rather obvious factors that do seem to support the shape of the curve are the increase in VAT to 20% and the continuing rise in self-employment, both of which serve to reinforce the contribution of cash to the shadow economy.

Half of UK banknotes used to fund shadow economy

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Charles and Jonathan estimate that the grey economy in the UK could have expanded by about 3% of UK GDP since the beginning of the current financial crisis. That means there are an awful lot of people not paying tax, and simple calculations will show that the tax lost that can be attributed to cash is vastly greater than the seigniorage earned by the Bank of England – the money the bank earns from issuing notes. Cash makes the government considerably worse off – and that means us.

It is time for Bank of England to develop an active strategy to start reducing the amount of cash in circulation instead of messing about with the distraction of who should be pictured on our new plastic notes (it should, of course, be Sir Thomas Gresham). For a start, they could take a look at what’s been going on in Sweden – where a broad alliance between the government, banks, trade unions (it is their members who get beaten up and stabbed in cash robberies) and Bjorn from Abba has made it the first country in the world where the amount of cash “in circulation” is falling.

There was a furore a couple of years ago when a government minister suggested that people who paid their builders in cash ought to be prosecuted for conspiring to defraud the Inland Revenue. The truth is he had a point.